Does Size Really Matter?

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For some reason our culture equates size with success.

April 01, 2003

 

Contact John Burns

via e-mail at jburns@realestateconsulting.com

 

For some reason our culture equates size with success. The more homes a company builds, the more successful we assume that company must be. The 12 largest builders in the country, all of whom have publicly traded shares, have grown substantially during the past few years, and they have achieved a great deal of success. However, their success has not come at the expense of others in the industry. Consider:

Pretax profit margins: Most of the 12 publicly traded builders reported 10% to 14% pretax profit margins last year. That sounds pretty consistent with the figures I’m hearing from my private builder clients. So where is the competitive edge? It appears that the additional expenses of running a large company offset the economies of scale of purchasing power and low cost of capital.

 

Who Bought Whom?
 
Pulte Corp.
Del Webb Corp., Phoenix (2001)
D.R. Horton Inc.
Emerald Homes, Houston (2001)
Schuler Homes, El Segundo, Calif.
Lennar Corp.
Barry Andrews Homes, Forest Hill, Md.
Cambridge Homes, Fresno, Calif.
Concord Development, Palatine, Ill.
Don Galloway Homes, Charlotte, N.C.
The Fortress Group, McLean, Va. (2001)
The Genesee Co., Lone Tree, Colo.
Pacific Century Homes, Temecula, Calif.
Patriot Homes, Columbia, Md.
Summit Homes, St. Charles, Ill.
Sunstar Communities, Raleigh, N.C.
KB Home
American Heritage Homes, Kissimmee, Fla.
New World Homes, Tucson, Ariz.
Beazer Homes USA Inc.
Crossmann Communities, Indianapolis
Hovnanian Enterprises Inc.
The Forecast Group, Rancho Cucamonga, Calif.
The Quaker Group, Montgomeryville, Pa.
Standard Pacific Corp.
Colony Homes, Winter Park, Fla.
Westbrooke Homes, Miami
Westfield Homes, Tampa, Fla.
Technical Olympic USA Inc.
Merged Engle Homes and Newmark Homes in conjunction with a refinance of the merged entity
D.S. Ware Homes, Jacksonville, Fla.
Masonry Homes, Manchester, Md.
Meritage Corp.
Hammonds Homes, Houston
Perma-Bilt Homes, Las Vegas
Taylor Woodrow
Journey Homes, Scottsdale, Ariz.

The monopoly myth: Monopolies or oligopolies can make money because they single-handedly can determine the price of goods. Microsoft is an example of what can happen with a monopoly, though I've never felt like I overpaid for a Microsoft product. If this issue of PB proves anything, it's that the industry is in no danger of a monopoly. Consider:

 

 

 

  • The 12 largest builders purchased about 20 companies last year. At that pace, it would take them almost 20 years to own the last 388 of this year’s Giant 400, and if they do, that still would give them only a 32% share of the U.S. new housing market. Nationally, the home building business will remain fragmented.
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  • All the homes built in the country account for only 15% of the homes sold each year. With 85% market share, the resale market clearly determines the price of homes.

    Impact on suppliers and service providers: Large builders have been able to negotiate excellent prices on many of the residential construction materials and services used all over the country. However, the 12 largest builders account for only 12% of the homes built each year. For most suppliers and service providers, catering to large builders is important, but it's not the bulk of their business, and it won't be for many years.

    For the home builders and apartment developers not on the Giant 400, size is not the measure. These smaller companies achieve success through local market knowledge and good business sense. They monitor the behavior of their publicly traded competitors because it helps them identify opportunities for success.

    One of my favorite consulting clients is in the Giants' top 100 firms and builds primarily in a market where significant public builder consolidation has occurred. Here is my view on how consolidation in the industry has affected this company:

    Capital - My client has access to more capital than it can possibly use. It has five institutional equity sources for land development deals, and each investor's required return is not significantly different from the expected return on buying the stock of a public builder. Each source consistently puts up most of the cash for acquisitions, and all five compete with each other to be the chosen investor on the next deal. The capital partner gives my client a management fee sufficient to offset overhead expenses even if the market slows. All five equity partners come from different industries, so my client is protected in case one or two industries collapse.

    Purchasing power - My client pays more for products than some of the really large builders. However, most of the subcontractors and service providers in its market fight for their business. Construction and service always will be local businesses and bid based on job size rather than company size. My client also pays its bills quickly, which is just as important as price to many small companies.

    Land acquisition - My client has abandoned master-planned communities where public builders are willing to sacrifice profitability for volume. But this has helped my client focus its land acquisition efforts on some of the more difficult parcels to acquire. It is doing more due diligence on land acquisitions, which is allowing it to outbid public builders on some parcels because it has more knowledge of the property and more confidence in future revenue and costs.

    Compensation - Here is where public builders have an advantage. It becomes challenging for private builders to retain top management when top managers hear what their counterparts at public builders are paid.

    First, the publics pay enormous bonuses when times are good. The highest-paid executive in Los Angeles County last year was a home builder. Most of the division executives at that company were paid huge bonuses as well. My client paid bonuses, too, but it didn't seem right to my client to distribute a large percentage of profits to employees when the owners took all the risk. Wall Street doesn't seem to mind.

    Second, public builders can offer lucrative stock options to employees. While private builders also can offer ownership opportunities, ownership in a private company is far less liquid than ownership in a public company.

    Strategic planning for a downturn - My client has spent significant time and money pre-paring for the next downturn in housing. It believes that banks are unlikely to become property owners because their lending policies have been so conservative, and the industry won't be plagued by an oversupply of built, unsold homes. What will be different, and concerns my client the most, is the manufacturing mentality adopted by public builders. Rather than slowing production to meet demand, my client fears that public builders will maintain level production and reduce prices to keep homes selling.

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